How Do You Conduct A Bank Stress Test?

The idea of a banking stress test is pretty appealing. You go in, look at the books, and then look at how bad the books could get in a variety of scenarios to get a sense of which banks are likely to go under and which ones can be salvaged. That banks would be required to undergo such a test was one of Tim Geithner's few specific proposals when he unveiled the government's banking plan a couple weeks ago.

But how do you actually do it? Some, like Yves Smith, have argued that the numbers of inspectors going into the banks are way too small, and that there's no way 100 bureaucrats could get a handle on the safety of a bank as large as Citi.

Eric Falkenstein notes another problem: There's no accepted way of conducting a stress test that won't just be arbitrary, political and subject to gaming.

Any quick, nationwide stress test will be arbitrary. Regulators do not have a lot of experiencing assessing economic risk capital to 'good' assets. Historically, they merely check leverage ratios (tier 1, tier 2, total), and then make sure various level of bad loans are in their proper buckets (OAEM, Substandard, Doubtful, Loss).

So, a test might be something like, assume all assets can lose 10% of their value. This necessarily penalizes banks with lots of high quality assets, because it treats BB rated bonds like AAA rated bonds, and even with the recent surprises, one should not assume every liability has the same probability of going into default. A stress test should apply the stress based on their historical loss rates, looking at the institution and industry-wide data, but that would generate a large amount of differentiation and complexity, and this would generate a lot of haggling over important, real, differences of opinion, and sheer politics as some use legitimate issues as cover for naked opportunism. It is inherently complicated, and even though we would like a solution quickly, it is counterproductive to attempt a quick solution in this situation.

Now, doing this quickly would stop the contagion issue, but only by being arbitrary.

Now, we imagine some will dismiss this on the idea that we just can't have these zombie banks running around and that an arbitrary stress test is better than what we have, which is nothing at all. But arbitrariness is what makes it impossible to invest private capital into the banking system. In an arbitrary system, all banks, regardless of their health, are nationalization candidates